January 2020 Fed Note

The Federal Open Market Committee (FOMC) completed their January meeting, with no stated changes in monetary policy, and no dissents. The target fed funds rate remains at 1.50-1.75%.

The formal statement was little changed, noting low inflation and economic growth expanding at a ‘moderate’ pace, although household spending was downgraded from ‘strong’ to ‘moderate’ as well, in the only notable difference from December. While insignificant to monetary policy overall, the Fed did raise a unique rate it pays to banks for excess reserves kept at the Fed from 1.55% to 1.60%—more toward the ‘mid-range’ of the fed funds target. This relates to an ongoing desire to balance incentives for borrowing and lending in the short-term ‘repo’ markets, which has proven a little tricky in recent months.

As for the Fed’s key decision items, little has changed from the prior meeting. This is in line with the lack of policy adjustment today or even hints of future action.

Economic Growth

GDP for Q3 came out just over 2%, and growth for Q4 is expected to be at about the same pace. While manufacturing has fallen into a soft patch recently (although the month-to-month data is sporadic), services activity and consumer spending remain strong. Consumer activity has largely been a byproduct of a strong employment market, noted below. Estimates for overall growth for the next several years remain pegged in this same 1.5-2.5% range, with little variation, as there are low expectations from economists for a breakout (such as a growth spurt to 3-4%). Accordingly, this has translated into continued low assumptions for inflation and interest rates.

Inflation

CPI for 2019 came in at a level of 2.3% on both a headline and core level, which is slightly higher than in prior months. When incorporating differences in the composition of goods and services, this remains in line with the Fed’s preferred PCE inflation measure of 2.0%. The Fed has been very concerned about inflation not running ‘hot’ enough, while overall inflation continues to mask divergent results between various segments.

Employment

Labor markets have flattened a bit, meaning that continuous improvement has been harder to achieve, but in general conditions remain very good. In fact, as measured by the low unemployment rate, low levels of jobless claims, and low layoff numbers, conditions are still at a multi-decade and generational peak. Continued choppiness or declines in manufacturing (albeit an increasingly small part of the economy relative to services), a re-escalation of trade woes, or an impact from the coronavirus, could threaten this strength, as would a recession, but for now, the fundamentals remain intact.

Interest rates are extremely fickle and difficult to predict in the short-term, notably due to their reactionary nature to conditions in broader financial assets. At this time, the risks of sharply higher rates appear low, reliant on inflation or growth ticking dramatically higher. On the other hand, lower rates could result from an economic growth slowdown or recession. Currently, the thin balance appears to be somewhere in between.

Financial markets reward the removal of uncertainty almost more than anything else. Almost as interestingly, in recent years, the Fed has expressed a preference for avoiding communication uncertainty as well. Now that they cut the fed funds rate three times in 2019, they’ve also made it clear that they were ‘done’ for the time being. This is until at least inflation picks up to far higher levels, or we enter into a recession and need the ammunition that rate cuts would provide.

Author: Ryan Long

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